China is about to unleash the same policy that blew up the stock market earlier in the year

Yesterday, as has been the case for much of the past few months, Chinese stocks staged another amazing rally. Led by brokerage firms, the benchmark Shanghai Composite put close to 2%, extending the indice’s recovery from this year’s low to 28%.

The catalyst for the rally was news over the weekend that China’s stock market regulator, the CRSC, will allow the resumption of IPO listings following a ban put in place amidst the stock market rout in mid-June.

According to analysts at Credit Suisse, the resumption of IPO listings is likely to lead to further gains in Chinese stocks in the period ahead. They suggest it will introduce additional investor funds into the market, particularly as as the returns from an IPO subscription are, on balance, significantly higher than those in the money market and for wealth management products (WMPs).

“Individual investors believe the upcoming IPOs will bring them ‘risk-free’ returns as usual—they will move their money from the money market and WMPs to the equity market to chase better opportunities,” Credit Suisse note.

Risk-free returns, from a market that rose 150% in the year to June before crashing nearly 50% over the next three months?

Credit Suisse explain how the government essentially guarantees substantial investor returns, ensuring herd-like behaviour before and after a new company is listed.

“In 1H 2015, the new stocks were priced at 20-23x P/E, while the ChiNext market was traded above 70x P/E. Therefore, the new stocks generally increased 2.5x in the first 20 trading days,” they note.

“The new stock prices were controlled by regulators at ‘reasonable valuation’ to protect the interests of small retail investors. Therefore, the investors believe the return of buying new stocks is risk-free return, which is sort of guaranteed by the regulator.”

Essentially the government, through the CSRC, substantially undervalues the value of the company before listing, at least based upon the eye-watering price to earnings ratios for small-cap stocks listed in China, ensuring enormous initial profits for investors in the days following an IPO listing.

The table below, supplied by Credit Suisse, reveals the enormous gains for newly listed shares in the first half of 2015.

Yes, you’re reading that correctly. The average IPO listing in May saw stocks jump by an average of 345% in just 20 days.

No wonder investors were flocking to the market in order to get a piece of the action, and why the benchmark index subsequently tanked only weeks later.

A strong IPO listing performance is a desirable outcome, not just in China, but that’s taking it another level.

Despite the lessons of the past few months, it’s likely, at least according to Credit Suisse, that the government will continue with this practice when the ban on IPOs is lifted in less than a fortnight.

“The main board is now traded at 22x P/E, but the Chi-next board (small caps) is at 88x P/E. We believe the new stocks will be priced between 20x and 30x P/E as the regulator still wants to protect the interests of small investors,” says the bank.

“The possible big gap between new stocks and listed stocks should also generate high returns.”

While the government is attempting to reduce debt levels for Chinese firms, essentially allowing them to replace debt with investor equity, one has to question why they chose the method of deeply discounting new issuance in order to generate instant profits for investors.

Yes, it will help prise a small percentage of China’s massive household savings into the market, but it is reinforcing short-term thinking from investors, something that contributed substantially to the wild swings in stocks seen earlier this year.

Combined with what many deem to be ridiculously high price to earnings ratios – indicating that either stocks are grossly overvalued or likely to experience massive earnings growth in the future – the government’s actions, yet again, are sowing the seeds for substantial volatility based on short-term thinking in the future.

While speculation is an essential part of any financial market, it is over the top in China. Fundamentals sadly play second fiddle to the likes of rumours, momentum and ensuring instant profits.

The government is openly encouraging this to occur through its current actions. Until that changes, China’s markets will remain more akin to a casino rather than a place to invest for the future.